Wednesday, October 24, 2012

After a three-decade bull run, investment-grade corporate bonds have
run out of room to generate any future double-digit returns. That’s
basically the conclusion of Bank of America Merrill Lynch
credit strategist Hans Mikkelsen, who says this year’s 10% return for
the high-grade market pretty much represents the last of its kind,
saying it’s “mathematically impossible” to replicate that type of return
again. Mikkelsen writes:

How do you start the year with a yield of 3.88% and
generate 10% returns by mid October? It seems unlikely that anybody
could have predicted by the end of last year that HG credit spreads
would tighten by 100bps and 10-year Treasury yields decline about 20bps.
You could have predicted the spread tightening, or the decline in
interest rates – but not both, in our view. Yet both happened because
the sharp decline in uncertainties – though clearly not in a straight
line – reduced credit risk, while growth declined so much that the Fed
had to backstop it. The average yearly total return in high grade for
the past three decades is 10% as well. With current yields of about
2.75% we think it is mathematically impossible to generate another 10%
return going forward. With today’s market we have reached our 155bps
year-end spread target for high grade. However, with improving
fundamentals and strengthening technicals we mark-to-market our year-end
target to 140bps, or 5bps inside the post-Lehman tights reached in
April last year.